For Professional Use Only
August 2015
MindScope
In-depth insights on important developments for markets and investors
Academic society and practitioners bring a clear message: market prices are driven not only by traditional market
premia, but also by other structural sources of reward, or “factors”. Factor Investing is the practice of intentionally
capturing these factor premia and improves the risk-return profile of portfolios.
Factor Investing: how to improve portfolios
by allocating to factors as building blocks
www.nnip.com
MindScope
August 2015
Boost the risk control, expected returns
and diversification of your portfolio with
Factor Investing
Many institutional parties are adopting or considering Factor
Investing. What is Factor Investing, why is it relevant for investors, and how do we suggest investors utilize Factor Investing
in their portfolios? Guido Baltussen, Senior Strategist, and Bas
Peeters, Head of Quantitative Research & Strategy of NN
Investment Partners, answer these questions in this MindScope.
1. Introduction
Spurred by the advice of academics, many institutional investors
are adopting or considering Factor Investing. What is Factor
Investing? Why is it relevant for investors? And, how can investors
utilize Factor Investing in their portfolios? In this MindScope we
will answer these questions. We start with a bit of theory, explaining the concept of Factor Investing (Section 2), the benefits of
Factor Investing (Section 3), and an outline of the academic origin
of Factor Investing and its impact on ‘manager alpha’ (Section 4).
Next, we turn more to practice, outlining factors we deem are
highly interesting for investors (Sections 5 and 6), showing the
benefits they bring to portfolios (Section 7), and how to put Factor
Investing in practice (Section 8). Finally, Section 9 concludes.
returns. In other words, a factor is a structural driver of the risks
or returns of your portfolio. Examples are the “traditional” equity
market factors, but also “alternative” factors like the value factor
and the momentum factor.
Factor Investing is rooted in academic society, with long-standing,
well-recognized academic studies showing the relevance of factors for investment portfolios. In one famous finance theory, the
Capital Asset Pricing Model (CAPM) developed in the 1960s, there
is a single risk premium on the market factor, which compensates
investors for exposure to non-diversifiable, systematic market
risk. Since then academics have put forward convincing evidence
that other systematic sources of return are structurally present in
markets. Well-known examples are the value premium in stocks
(Basu, 1977, Fama and French, 1992), the momentum premium in
stocks (Jegadeesh and Titman, 1993) and the carry premium in
foreign exchange (Froot and Thaler, 1990).
At the heart of Factor Investing, the practice of allocating to factors as building blocks of your portfolio, is the idea that the investor is compensated for assuming risks belonging to factors. Factor
Investing is based on the existence of factors that have earned
a premium over long periods, and are firmly grounded in the
academic theory. What then is a factor? A factor can be thought of
as a characteristic of a group of assets that systematically drives
You can compare Factor Investing to nutrients intake. For example,
let’s take one of the world’s most popular foods: the hamburger.
You can have two different views of the same hamburger. First, we
can focus at what we put on the burger: the ingredients. Typically,
these are two buns of bread, meat, lettuce, tomatoes, maybe
other vegetables, condiments, and so on, as shown in Figure 1.
This view gives a sense of the ingredient mix; we have (roughly)
45% bread, 30% meat, 10% tomato’s, 10% lettuce, etc. Although
the hamburger may look good and healthy from this perspective1,
it does not necessarily mean the mix fits well in the context of your
optimal nutrients need.
Figure 1: The portfolio hamburger: “Asset” view
Figure 2: The portfolio hamburger: “Factor” view
2. Factor Investing explained
Nutrition Facts
Serving Size 1 Burger (285g)
Serving Per Container
Amount Per Serving
Calories 750
Calories from Fat 410
% Daily Value*
Total Fat 45g
Saturated Fat 16g
69%
80%
Cholesterol 105mg
35%
Sodium 1,420mg
59%
Total Carhohydrate 52g
Dietary Fiber 3g
17%
12%
Sugars 9g
Protein 39g
Not a significant source of trans fat, Vitamin A, Vitamin C, calcium, iron.
* Percent Daily Values are based on a 2,000 calorie diet.
1
Obviously assuming you make the burger yourself with healthy ingredients.
2
August 2015
As an alternative view, we can look at what drives the “impact” of
the burger: the nutrients and how they fit with your health, preferences, and other considerations. After all, it is the nutrients in the
food that matter the most and drive health. For example, a typical
hamburger contains 45 grams of fat, 69% of the recommended
daily intake for the average person, and 52 grams of carbohydrate,
17% of the recommended daily intake (see Figure 2). Eating right
requires looking through ingredients to understand nutritional content: nutrients matter, not single ingredients, and too much “exposure” to specific nutrients (like fat, but also vitamins) is damaging.
In terms of an investment portfolio, the “ingredient view” corresponds to focusing on typical investment categories or allocation
buckets, like US equity manager A, Euro equities manager B, Euro
equities manager C, US bonds manager D, and others. This view
gives a sense of the portfolio composition, but it does not necessarily mean the mix fits well in the context of your investment
objectives. By contrast, the “nutrient view” tells us our actual portfolio composition and diversification in terms of factors that drive
risk and return.
Just as eating right means looking through ingredients for the
underlying nutrients, investing right means looking through investment categories for the underlying factors. How we think we are
diversified can differ from “reality” in the sense of exposures to
factors. This is relevant since factors are the main driver of the
returns on portfolios. Factor Investing is the practice of actively
steering on the “nutrients” (the factors), or in other words, allocating to factors as building blocks of a portfolio.
3. The benefits of Factor Investing
Factor Investing is beneficial because it helps allocating risk
more efficiently by focusing on “true” structural return drivers.
It involves analysing the “nutrimental content” of a portfolio
(that is, dissecting the hamburger), comparing the outcomes
with preferences, and filling in any deficiencies. As a consequence,
a portfolio is explicitly steered on factors, which helps to manage
risk and harvest performance drivers in a more diversified,
effective and generally lower cost manner.
In practice, many investors hold the belief that if they hold large,
well-diversified portfolios that have allocated to many different
alpha managers, they are well diversified and have substantial
alpha potential. Actually, we believe that this practice is likely to
lead to unintended (and possibly large) exposure to factors.
The reason is that in portfolios diversified over many instruments
(or managers) it is very hard to find “alpha” that is not related to
factors. Diversification causes idiosyncrasies to be swamped at
the portfolio level, while systematic exposures to factors tend to
add up. Therefore, if an investment portfolio is well diversified it is
highly likely that a significant fraction of its active return will be
driven by one or more systematic factors2. We believe that one
important must for a fund is to have insight in exposures to these
factors. Further, steering a portfolio on factors helps to get more
2
or example, overweighting 100 value-oriented stocks and underweighting 100
F
growth stocks is not 100 separate long-short investments: it is one bet on one
so-called value factor.
grip on the main risks of the portfolio; one becomes more aware of
potential return drivers of a portfolio and (possibly unintended)
exposures to them.
The Factor Investing approach generates a number of additional
side benefits. First, it creates awareness of exposures to portfolio
risk drivers and possibly improved portfolio diversification; focusing
on asset classes can lead investors to “double count” factors and
lead investors to overestimate the true amount of diversification
they are achieving. Second, it can lead to an enhancement opportunity of returns in case of previously unexposed factors. Third, Factor
Investing has a strong rules-based foundation and has therefore the
potential to make the investment process more transparent.
4. The evolution of Factor Investing
Factor Investing is not new or a temporary hype. Rather, the
current trend of Factor Investing is one of an evolution. Factor
Investing started in the 1970s with the introduction (and subsequent rise) of index funds. These funds followed from many studies
from well-recognized academics in the finance field of asset pricing conducted in the 1960s and 1970s, showing that asset returns
are driven to a great extent by market factors. Most notably was
the development of the CAPM by professor William F. Sharpe,
who would go on to receive a Nobel prize, and professors Jack
Treynor, John Lintner and Jan Mossin. In this model there is a single
structural return driver, the market factor, which compensates
investors for exposure to non-diversifiable and systematic market
risk. This was followed in the 1970s by the development of another
major theory of asset pricing that allows for a multiple of factors
driving returns, Stephen Ross’s Arbitrage Pricing Theory (APT).
During the 1970s and beginning of 1980s the investment industry
started to incorporate these findings by offering easy, transparent
and often lower-cost exposures to the main market factors (“beta”)
via the launch of equity and bond index funds. Nowadays, by far
most investors allocate to these market factors in their portfolios.
The current trend of Factor Investing extends the above logic to
“alternative” factors, or what we term “alternative premia”. Since
the 1980s and 1990s academics have shown the existence of a
number of alternative factors, over and above the existence of
market factors. In the next section we discuss these factors in
more detail. An important trigger for the current rise in Factor
Investing is the (nowadays dubbed) “professors’ report” of three
renowned professors: Andrew Ang (Columbia Business School),
William Goetzmann (Yale School of Management) and Stephen
Schaefer (London Business School), commissioned by the
Norwegian Government Pension Fund, one of world’s largest
investment funds, after large losses due to the 2008 crisis.
They critically evaluated the active performance of the fund and
found that 97% of the fund’s return could be explained by movements in the benchmark, and that approximately 70% of the
remaining active performance could be explained by exposures to
various systematic factors. The analysis further highlighted that
these factor exposures were actually a by-product of bottom-up
active manager selection by the fund. This all triggered the professors to advise the Norwegian Fund to aim for a more intentional
and top-down approach to taking factor exposures, not only the
3
MindScope
August 2015
market factor but also alternative factors. We believe this advice
is applicable to a very broad investor base. In addition, we have
identified five of such alternative factors that robustly and consistently drive returns across all major asset classes and markets.
Factor Investing and its evolution has important consequences for
the thinking about “manager alpha”, as summarized in Figure 3
below. Before the 1970s/1980s it was believed all performance
was “manager α” (i.e. excess performance obtained by skills of
managers). Academics and the industry then discovered that
returns are partly driven by systematic exposure to the traditional
asset class premia (i.e. “market β”) that can be captured in a relatively easy manner via predefined investment rules, leading to a
first α – β separation. Similarly, the current evolution of Factor
Investing reveals that returns are partly driven by systematic
exposures to the alternative factors that (again) can be captured
via predefined investment rules, leading to a further redefinition of
manager alpha.3
Figure 3: The shifting paradigm of Investing
Pre - 1980
Post - 2010
1980 - 2010
Alpha
Active
Management
Alpha
Alternative
P remia
Factor
Investing
Market Beta
Passive
Investing
Alpha
Market Beta
B eta
All returns are
‘manager α’
α–β
separation
α further
decomposed?
5. A dive into our factors: the alternative premia
What, then, are the factors that could be relevant for me as investor? In our view, it makes most sense from an investment perspective to focus on two sets of factors, akin to the evolution of Factor
Investing. The first set of factors is the set of traditional asset
class or market factors, like the equity market factor and the bond
market factor. Typically, these factors are well-covered by all kinds
of indexing products (like ETFs). They are the benchmark for many
major asset classes and institutional investors and are nowadays
actively and explicitly allocated to by almost all investors.
The second set of factors are the alternative factors, or “alternative premia”4,5. These are the factors that do not statically invest in
assets, but dynamically allocate to assets, often in a long-short
and rules-based manner. They have been brought up by academics since the 1980s. For example, Fama and French (1992) investigated a value factor and showed that stocks with a favourable
value (for example, with a high book-to-market ratio) structurally
outperform stocks with an unfavourable value (stocks with a low
book-to-market ratio). As another example, Jegadeesh and Titman
(1993) investigated a momentum factor and showed that the top
performing stocks over the past year (the winners) continue to
outperform the bottom performers (the losers) over the next
months.
A complicating aspect is that many academic studies and market
participants propose a plurality of alternative factors. Some of
these are, we believe, the consequence of data-mining by
researchers and investment parties. Others are not easily exploitable from a practical perspective and some are true and relevant
alternative factors. Our approach in selecting alternative factors
is best described as “evidence-based investing”: alternative factors should have a clear theoretical foundation backed by substantial and strong empirical evidence. We believe in those factors
that have proven themselves over multiple decades and across
markets, and build upon solid economic theories. Academic studies guide us in the existence of a factor. At the same time, we are
well aware that not all research questions are yet answered about
different factors, especially related to how to most efficiently
implement a factor. Therefore, we also believe in a strong
research-driven process, relying on extensive in-house research
from an experienced research team.
Based on academic and extensive in-house research we have
identified the following alternative premia that generally are
present across most markets and asset classes and are well
exploitable and scalable in a liquid universe: Momentum, Value,
Carry, Flow, and Volatility. These factors drive returns because
they (i) offer exposure to risk that other investors wish to avoid
(a risk transfer, similar to the idea of insurance premia), (ii) profit
from systematic mispricing opportunities created by investors’
behavioural biases (a market inefficiency), and/or (iii) provide
compensation for accommodating market imbalances that result
from investment objectives and constraints (a market structure
compensation). The next section describes the definition, the idea
behind and the evidence in favour of these alternative premia in
more detail.
ome practitioners dub these as ‘styles’. We prefer the term ‘alternative premia’.
S
Many investors think of the Morningstar classification based on size and value in
stocks when referring to styles. The alternative premia go beyond that, as will
become evident in the next section of this paper.
5
An alternative approach seen in the market is to focus on so-called ‘macro factors’:
factors that capture underlying macro-economic risks that drive the returns on
assets. Examples are an inflation factor, an economic growth factor, a political risk
factor, and an uncertainty factor. The drawback of these ‘macro factors’ is that none
of these are directly tradable (in large scale), and all kinds of imperfect proxies have
to be used in practice. For example, several investors choose to proxy the economic
growth factor by the MSCI World returns. We therefore believe it is more efficient
and effective to focus on the traditional factors and the alternative premia.
4
3
I n fact, many investors argue that the current form of Factor Investing is in
between active and passive. We agree with this point, but would also like to highlight that the main idea of Factor Investing is about identifying structural and persistent drivers of return on portfolios (i.e. factors), and ensuring a balanced, controlled exposure to them.
4
August 2015
Momentum
• Long the winners, short the laggards
Value
• Long cheap assets, short expensive ones
C arry
• Long high-yielders, short low-yielders
Volatility
• Long cheap volatility, short expensive
volatility
F low
Quality
• Long excessive supply, short excessive
demand
• Long high quality assets, short low quality
What exactly do the various alternative premia entail? In a
nutshell, the idea behind momentum is that securities that have
performed relatively well (poorly) over the past months to year,
tend to continue to perform well (poorly) over the near future.
In other words, “the trend is your friend”, as captured by taking
a long (short) position in recent winners (losers).
The idea behind value is that in the short run, prices are subject
to over- or under-valuations, but in the long run, securities prices
tend to converge to their fair value. That is, “cheap outperforms
expensive”. The value factor can be captured by taking a long
(short) position in cheap or undervalued (expensive or overvalued)
assets.
Carry captures the return that you would earn when taking a
position and when markets would not move, also known as “yield
pick-up”. This factor can be captured by taking a long (short)
position in high-yielding (low-yielding) assets.
The idea behind the volatility risk premium is that volatility tends
to be priced higher than it should be according to its rational
expectation, and is captured by taking a positive exposure to
(priced) volatility risk.
Finally, the idea behind flow is that markets are in the short
run subject to predictable and excessive buying and selling
pressures that temporarily drive market prices up or down.
ee for example Fama and French (1992), Jegadeesh and Titman (1993), Ang,
S
Hodrick, Xing and Zhang (2006).
7
In addition, we believe in a ‘Quality’ factor in individual stocks, as shown by, among
others, Novy-Marx (2013, 2014).
6
Figure 5: Historical (risk-adjusted) performance of
alternative premia
IR
Momentum
Value
Carry
Flow
Equity
0.52
0.59
1.12
0.85
0.97
Bond
250
0.70
1.04
0.61
1.32
0.44
0.86
Equity
Equity
0.13
0.79
0.64
0.77
0.67
1.31
1.28
Cumulative
Cumulative
Cumulative
return
Cumulative
return
(%)return
(%)return
(%) (%)
Figure 4: Our alternative premia
Figure 5 shows the historical performance of the alternative
premia over the February 1992 – September 2014 period for liquid,
well-investable instruments in the most important asset classes.
Shown are the historical return per unit of volatility, as reflected in
the Information Ratio per annum (IR; top panel) and the cumulative performance over time (bottom panel) per factor per asset
class, as constructed from our in-house database and targeting at
a 5% volatility per factor per asset class.
FX 200
0.57
250
150
Commodities
0.93
Cumulative
Cumulative
Cumulative
return
Cumulative
return
(%)return
(%)return
(%) (%) Cumulative
Cumulative
Cumulative
return
Cumulative
return
(%)return
(%)return
(%) (%)
Figure 4 lists our alternative premia universe, and the trading
strategies underlying them. Both our in-house research and many
academic studies have documented the existence of these alternative premia in stock selection, or “bottom-up”6,7. Especially in
this space, many investment parties are now adopting Factor
Investing. We believe there is also ample economic underpinning
and historical evidence for the existence of these alternative factors in top-down Equity, Fixed Income and, more in general, Multi
Asset space. Also in these landscapes the factors have the ability
to significantly enhance the returns and diversification benefits of
a portfolio, as we will show in the remainder of this MindScope.
Accommodating these flows or providing liquidity allows investors
to reap return from these temporary mispricings, and is captured by
taking a long (short) position in assets in excessive supply (demand).
200
250
100
200
150
50
250
150
100
0
200
100
50
Equity
Volatility
Equity
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
150
50
0
100
0 jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
50 jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
0
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
Momentum
400
Value
300
400
200
400
300
100
300
200
400
0
200
100
300
jan 92 jan 94 jan 96
100
0
200
0 jan 92 jan 94 jan 96
100 jan 92 jan 94 jan 96
0
Momentum
jan 92 jan 94 Value
jan 96
200
Carry
Bond
Flow
Volatility
Bond
Bond
Bond
jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
FX
Carry
Flow
jan 98
jan 00 jan
02 jan 04Volatility
jan 06 jan 08 jan 10 jan 12 jan 14
FX
150
200
FX
100
200
150
FX
50
150
100
200
100
0
50
150
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
50
0
100
0 jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
50
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
Momentum
0
Value
Carry
Flow
Volatility
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
Commodities
Cumulative
Cumulative
Cumulative
return
Cumulative
return
(%)return
(%)return
(%) (%)
6. Alternative premia work everywhere and over
the long run
400
300
400
200
400
300
Commodities
Commodities
Commodities
100
300
200
400
0
200
100
300
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
100
0
200
Momentum
Carry
Flow
0 jan 92 jan 94 Value
jan 96 jan 98
jan 00 jan
02 jan 04Volatility
jan 06 jan 08 jan 10 jan 12 jan 14
100
Source: jan
NN92
IP jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
0
jan 92 jan 94 jan 96 jan 98 jan 00 jan 02 jan 04 jan 06 jan 08 jan 10 jan 12 jan 14
5
MindScope
Clearly, all our alternative premia display a very strong historical
performance. They tend to work in every market, and tend to
perform over the long run.
Some investors might wonder whether the alternative premia
continue to offer expected rewards going forward. We strongly
believe these factors will continue to perform over the long run
for the following reasons.
First, they are supported by extensive academic and empirical
research that demonstrates the existence of these factors over
very long periods of time and a wide range of markets. For example, our in-house research shows that momentum works in almost
every asset class, and Chabot, Ghysels and Jagannathan (2014)
and Geczy and Samonov (2014) show that it can be found even
in the Victorian age in the UK market, and since the 1800s in the
US stock market. This leads us to believe that our factors are not
merely a fluke.
August 2015
7. Factor Investing in a portfolio context
Alternative premia can significantly enhance the returns and the
diversification benefits of a portfolio. They offer attractive returns
(as shown in the previous section) and generally have a low
dependence with the traditional factors (asset classes). To illustrate the latter we have computed the (monthly) correlations
between the main asset classes (as shown in the upper part of
Figure 6), the correlation between the main asset classes and
each alternative premium averaged across the various asset
classes (by means of a volatility-weighted average as shown
in the middle part of Figure 6), and the correlation between each
alternative premium across the various asset classes (as shown in
the lower part of Figure 6). The sample period starts in October
1993, the earliest month returns on all series are available, and
runs till September 2014.
Figure 6: Average correlation between factors / asset
classes
Equity
Second, we believe we have a good understanding of the under­
lying mechanisms that cause these factors to exist, and believe
them to remain a structural driver of returns going forward. More
specific, alternative premia offer a compensation for taking on
risk that some investors choose to avoid (for example due to
their investment objectives), but are not a worry for other type of
investors. This is a rational source of reward and a structural part
of the economic system. Further, alternative premia profit from
behavioural biases in combination with limited arbitrage forces.
The history of men and findings from the academic field of
psychology and behavioural finance teach us that behaviour
generally is very hard to change and behavioural biases are very
persistent. The erosion of limits to arbitrage would require strong
financial innovation and changes in market structure. Finally,
alternative premia reflect a compensation for accommodating
market imbalances that result from investment objectives and
constraints. This tends to be a reflection of how the market is
organized and segmented, which is well-rooted in the structure of
the financial system. We therefore believe these factors continue
to perform in the coming years, also if the practice of Factor
Investing is being adopted more broadly.
We note that to move from Factor Investing theory to practice
demands both quantitative expertise and practical experience.
A lot of potential rewards of the alternative premia can be lost
in “dumb” or “naive” implementation or portfolio construction.
We believe that an efficient way of providing investors with access
to the alternative premia must account for aspects like efficient
implementation at mitigated transaction costs, and exposure to
unintended (and potentially unrewarded) risks hidden in a factor.
In addition, we especially care how and why a factor works, since
knowing so prevents us from selecting data-mined strategies that
should not be expected to deliver going forward. It also helps in
getting a better grip on factors and how to most efficiently implement them, and tells us how we expect the factor to return going
forward. For more information about our precise way to capture
the alternative factors, please contact your local sales representative or one of the authors.
Equity
Bond Commodities
Hedge
Funds
1.00
Bond
0.14
1.00
Commodities
0.42
0.28
1.00
Hedge Funds
0.82
0.05
0.48
1.00
Mom.
Value
Carry
Equity
-0.13
-0.03
-0.02
-0.08
0.12
Bond
0.15
-0.19
0.06
-0.14
-0.04
Commodities
0.09
-0.20
-0.01
-0.15
0.15
Hedge Funds
0.03
-0.07
0.06
-0.01
0.10
Mom.
Value
Carry
Momentum
Flow Volatility
Flow Volatility
1.00
Value
-0.28
1.00
Carry
0.13
-0.21
Flow
0.05
0.07
0.11
1.00
-0.08
0.06
0.00
0.01
Volatility
1.00
1.00
Source: NN IP
The traditional factors tend to have moderate to large positive
correlations, while all the alternative premia tend to have close to
zero or slightly negative correlations with the traditional asset
classes. Moreover, the alternative premia also tend to have close
to zero or negative correlation with each other. This suggests that
it is especially beneficial to combine alternative premia in a multi
factor portfolio8, and to add this to a traditional portfolio.
8
oreover, a multi factor portfolio allows for additional benefits such as lower turnM
over as a result of trade crossing. Further, we believe factor returns fluctuate over
time, responding to among others macro-economic and market forces. As a consequence, they can underperform for periods of time that may exceed an investor’s
patience. Diversifying across multiple alternative premia helps in building a more
robust portfolio and benefits from the low dependence across alternative premia.
6
August 2015
400
300
200
100
0
Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08
Figure 7: How alternative premia improve the risk-return
of a portfolio
Equity port.
Bond port.
Bond + 10%
Multi Factor
Avg. return (ann.)
22.89
5.41
7.23
Volatility (ann.)
10.65
6.49
5.84
700
2.15
0.83
1.24
600
-14.66
-8.56
-6.48
Sharpe (net)
Max. drawdown
Equity
Multi Factor
Equity port.
Equity + 10%
Multi Factor
14.25
7.25
8.10
15.16
13.72
1.42
0.48
0.59
-12.71
-53.65
-48.24
100
Multi Factor
60-40 port.
60-40 + 10%
Multi Factor
0
Avg. return (ann.)
Volatility (ann.)
Sharpe (net)
Max. drawdown
33.05
6.81
9.53
10.51
9.84
8.89
3.15
0.69
1.07
-8.98
-34.82
-28.51
Fixed Income
350
300
Cumulative Return (%)
250
200
150
100
50
0
Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08
Bond port.
Jan 10
Jan 12
Jan 14
Bond port. + 10% Multi Factor
Jan 10
Jan 12
Jan 14
Equity port. + 10% Multi Factor
400
10.03
Multi Asset
Jan 14
500
Avg. return (ann.)
Max. drawdown
Jan 12
Multi Asset
Volatility (ann.)
Sharpe (net)
Jan 10
Source: NN IP
Multi Factor
Cumulative Return (%)
Fixed Income
Equity
500
Cumulative Return (%)
To illustrate the benefits alternative premia can bring to a portfolio, we show in Figure 7 the historical impact of adding a basic
multi-factor solution to a typical portfolio between October 1993
and September 2014. We take three typical portfolios: (i) a Fixed
Income portfolio (100% invested in BofA ML Global Government
Bond Index), (ii) an equity portfolio (100% invested in MSCI World),
and (iii) a conventional 60%-40% equity-bond portfolio (60%40% combination of i) and ii)). Next, we replace 10% of the portfolio by an equal-weighted multi-factor portfolio that targets a 10%
volatility per annum in either: (i) liquid Fixed Income space, (ii) liquid top-down Equity space9, and (iii) liquid Multi Asset space (all
net of estimated transaction costs)10.
300
200
Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08
60-40 port.
60-40 port. + 10% Multi Factor
Source: NN IP
Multi Factor solutions in each space (Fixed Income, Equity and Multi
Asset) enhanced the net returns of a typical portfolio by about 1 to
3% per annum. In addition, the diversification of the portfolio
improved; both volatility and drawdowns decreased significantly.
The above employs a relatively basic portfolio construction to
illustrate the potential benefits of Factor Investing. Clearly we can
improve upon these. Generally, we would advise diversifying
across multiple factor premia to avoid possible long-lasting drawdowns on individual factors, which are generally mitigated and
shortened when diversifying across multiple factors. We believe
that a robust, efficient portfolio construction approach that
accounts for tail risks is required to efficiently and effectively
combine the alternative premia and achieve its potential. In fact,
a lot of the potential rewards of the individual alternative premia
and diversification benefits across them can be lost in a “naive”
combination and implementation.11
Source: NN IP
o emphasize, we add a top-down equity factor solution here implementable in
T
liquid instruments. Many studies show, in addition, the benefit of adding bottom-up
alternative premia in equity space, as outlined in footnotes 5 and 6.
10
Estimated transaction cost numbers are 4.7%, 2.8%, and 5.0% per annum for the
Fixed Income, top-down Equity, and Multi Asset spaces, respectively.
9
11
or more specifics about our approach, please contact your local sales representF
ative or one of the authors ([email protected] or [email protected]).
7
MindScope
August 2015
8. Putting Factor Investing in practice
9. Summary and conclusion
How can the insights from Factor Investing be used to actually
improve the risk and return characteristics of your portfolio?
Our advice is to start with analysing the “nutrimental content” of
your portfolio (that is, dissecting the hamburger), in order to obtain
a complete picture on both the traditional and alternative factor
exposures that are present. The next thing is to compare the outcomes with your preferences about all these factor exposures,
which can be related to your return ambitions, risk tolerances,
investment believes, and regulatory, operational or other constraints. If preferred we can assist you in these first two steps.
The final step is to fill in any deficiencies, or in other words imposing (alternative) factor twists on the current portfolio. Different
factor solutions may provide the best fit, depending on, among
other things, a client’s portfolio composition, governance structure and investment process.
Many institutional parties are adopting or considering Factor
Investing: the practice of allocating to factors (i.e. structural drivers
of returns) as building blocks of your portfolio and harvesting
factor premia intentionally and efficiently. Factor Investing is
based on the existence of factors that have earned a premium
over long periods, and are deeply grounded in the academic literature. Just as how eating right means looking through ingredients
to understand nutritional content, investing right means looking
through investment labels for the underlying factors.
Typically, a shortage of alternative premia in a portfolio can be
overcome via allocation to a multi factor fund or mandate, or via a
multi factor overlay on an existing portfolio. For example, in multi
asset space, this can take the form of a multi asset multi factor
fund or overlay mandate, financed either as a separate sleeve of
the Strategic Asset Allocation budget or as allocation out of the
multi asset or alternatives bucket. In Fixed Income space this
can be implemented similarly, or via a combination of long-only
traditional beta exposure in Fixed Income combined with a Fixed
Income only alternative factor overlay financed out of the Fixed
Income allocation of a portfolio. Similarly, for Equity this can be
implemented also via a combination of long-only traditional beta
(or a bottom-up factor tilted exposure) in Equity combined with an
Equity only (top-down) alternative factor overlay financed out of
the Equity allocation of a portfolio.
Disclaimer
The elements contained in this document have been prepared solely for the purpose
of information and do not constitute an offer, in particular a prospectus or any
invitation to treat, buy or sell any security or to participate in any trading strategy.
This document is intended only for MiFID professional investors. While particular
attention has been paid to the contents of this document, no guarantee, warranty
or representation, express or implied, is given to the accuracy, correctness or completeness thereof. Any information given in this document may be subject to change
or update without notice. Neither NN Investment Partners B.V., NN Investment
Partners Holdings N.V. nor any other company or unit belonging to the NN Group,
nor any of its officers, directors or employees can be held direct or indirect liable or
responsible with respect to the information and/or recommendations of any kind
expressed herein. The information contained in this document cannot be
We believe that the factors, or alternative premia, outlined in this
MindScope and supported both by extensive in-house and academic research, are of high interest for investors. Allocating to
factors offers attractive reward potential and better diversification, and helps to improve the risk-return profile of a portfolio.
Doing this in a “Factor Investing way” (meaning top-down and
intentionally) gives you better control of the risk of your portfolio.
The precise Factor Investing solution that would best suit you as
an investor depends on your needs, constraints and preferences.
Our advice is to start with analysing the “nutrimental content” of a
portfolio, comparing the outcomes with preferences about factor
exposures, and subsequently filling in any deficiencies. We can
assist you with further advice on this matter, and more generally,
on the role Factor Investing can play in your portfolio.
If you would like to have more information about NN IP’s
Factor Investing capabilities and solutions, and the role
Factor Investing can play in your portfolio, please contact
Guido Baltussen ([email protected]) or Bas Peeters
([email protected]) or your local sales representative.
understood as provision of investment services. If you wish to obtain investment
services please contact our office for advice. Use of the information contained in
this document is solely at your risk. Investment sustains risk. Please note that the
value of your investment may rise or fall and also that past performance is not
indicative of future results and shall in no event be deemed as such. This document
and information contained herein must not be copied, reproduced, distributed or
passed to any person at any time without our prior written consent. This document
is not intended and may not be used to solicit sales of investments or subscription
of securities in countries where this is prohibited by the relevant authorities or
legislation. Any claims arising out of or in connection with the terms and conditions
of this disclaimer are governed by Dutch law.
8